Greg Blotnick – CFA/NYSSA Membership, LinkedIn and Facebook

Author: Greg Blotnick

Greg Blotnick is currently a long/short equity analyst at a private investment firm, covering consumer, TMT and industrial stocks. Greg Blotnick has spent his entire career in the asset management industry and served as a fundamental analyst for former multi-billion dollar hedge funds. Greg's experience spans multiple investment strategies including long/short equity, credit, event-driven and capital structure arbitrage. Blotnick holds an MBA from Columbia Business School and a B.S. in Finance from Lehigh University, and is a CFA Charterholder. He can be reached at gregory.blotnick@gmail.com.

Small caps set to benefit more under Trump administration

tax rate the key driver (and lack of foreign revenue)

Greg Blotnick IWMs

IWM’s “have become a show me story. The main DRIVER supporting small cap is Economic Indicators & Policy, as small tends to lead when real US GDP is 2-3% range. Small caps also benefit from protectionism due to lower international exposure (19% of revenues in the R2000 vs. 31% for the S&P 500) and the pursuit of a lower corporate tax rate in Washington (we estimate the R2000’s effective tax rate is 32% vs. 26% for the S&P). The small/large trade has also been positively correlated with interest rates since the Financial Crisis, meaning further increases in yields are likely to be accompanied by small cap outperformance. Retail Money Flows initially favored small cap post-Election, with inflows returning, but have started to trend positive for large again in the latest ICI update (we are watching trends here closely). Importantly, Valuations no longer support small over large, as our model is nearly back to neutral (though not expensive yet). On Investor Sentiment, a higher VIX should not derail small cap outperformance for the year as a whole, as long as the average for the year remains subdued (i.e. <25).

Second, the potential for softer regulation and non-enforcement may make accretive acquisitions increasingly difficult due to fewer projects being built, even for platforms with strong ROFO lists. Third, we believe slowing growth expectations would likely de-risk Street expectations and provide support for these names.

We continue to highlight HASI as a top pick given management’s history of managing through cycles and maintaining investment flexibility across multiple asset classes. We continue to be constructive on CAFD and NEP given their access to projects to support growth and PEGI given relatively attractive valuation.”

Small caps saw the most PE expansion since April ‘09

In November, the forward PE for small caps hit a 20-month high, jumping nearly two multiple points to 18.4x from 16.6x as the Russell 2000 rallied 11%. This was the biggest monthly rise since April 2009 and more than double the multiple expansion of any other size segment during November. As a result, small caps now trade at a double digit premium to their historical median since 1985 across all of the five valuation metrics we track, led by PE to growth at a 60% premium. The current PE is 21% above its historical median of 15.2x since 1985, and near the cycle-high of 19.1x in 2014. Overall, valuations across size segments expanded in November as all size segments posted gains for the month.

Small caps now trade above their historical premium to large. Based on forward PE, small caps went from trading in-line to large caps to trading at a 9% premium in November, higher than the historical 7% median premium since 1985 (for the first time since mid-2015) but well below the most recent 30% peak in 2011.

The lack of security features on Internet of Things (IoT) devices could have fatal consequences, according to expert testimony at a recent House Energy and Commerce Committee hearing. As reported by Technology Review, computer security experts testified that computers used in hospitals and other sensitive facilities to control elevators and ventilation systems feature poor security. As a result, these connected devices are vulnerable to hacking, like the webcams, camcorders, and baby monitors that were attacked to cause a widespread Internet outage in the eastern U.S. in October. However, an attack on a hospital could have far more serious consequences than lost Internet access,

and result in the loss of life. While the Dept of Homeland Security and National Institute of Standards and Technology have issued guidelines on securing IoT, some believe the government needs to create a regulatory body to test and approve IoT devices and set universal device standards. The growing adoption of IoT devices will continue to underscore the importance of security, thus benefiting IT hardware and supply chain companies with strong security offerings, including HPE and IBM, as well as those companies manufacturing IoT devices.

Market update – the Italian referendum outcome, while “bad” as far as risk sentiment is concerned, was also very consistent w/market expectations (the magnitude of the loss may have been a bit larger than anticipated but regardless “No” was expected to emerge victorious and contrary to other recent political events like Brexit or Trump, Renzi’s resignation isn’t likely to represent a seminal shift in either Italian or European politics).

Greg Blotnick – Lights

Markets saw brief weakness following the Italian referendum news but have quickly reversed – the EUR hit 1.05 but has since rebounded to 1.06+ (it is flat-to-down small), US futures touched 2179 but have since rebounded to ~2200 (up ~7-9 points), and Eurozone equities are up ~1%. Asian markets finished in the red, a function of timing (i.e. they closed before the post-referendum dislocation abated) and to a lesser extent the Taiwan/China news from the weekend (Trump talked to the Taiwan president late on Fri in a significant breach of protocol and decorum and he followed that up w/a tweet Sun night critical of China; while Trump’s team and the media are playing down the Taiwan call, the Washington Post said it was premeditated and deliberately provocative). With Italy out of the way the calendar of major macro events left on the 2016 thins even further (other than the ECB on 12/8, FOMC on 12/14, and 2017 guidance from industrials such as GE, there aren’t many scheduled catalysts left this year). However, the recent Trump trade/foreign policy comments does represent an underappreciated source of risk while his fiscal/regulatory agenda may be moderated/delayed as it makes its way through Congress (in fact the Taiwan developments and the Trump trade-related comments/events of the last week are arguably more incremental than the Italian referendum in that the former hasn’t been a big area of focus while the latter was very expected).

Calendar – the focus for Mon 12/15 will be on the US non-manufacturing ISM (10amET), Fed speakers (Dudley, Evans, and Bullard), and some analyst meetings (BDC, HA, BSFT, JCI, JUNO, Roche, and SLG).

Eurozone equities – the SX5E and SXXP saw brief weakness at the open before quickly rebounding (each is now up ~1%). All the major sub-groups are higher but autos, insurance, luxury, and retail are outperforming. Real estate, energy, and utilities are lagging (but each is still trading higher). The Italian FTSEMIB is underperforming the rest of Europe (but is only down small). The SX7P bank index is up ~0.75% although Italian banks are lagging. Luxury stocks are outperforming (Swatch, Christian Dior, Richemont, etc.)

Treasuries/sovereign bonds – TSY yields are up small (2 and 10yr yields are up 2 and 3bp, respectively). In Europe, Italy is the big focus – 10yr BTP yields are up ~12bp to 2.01% (keep in mind though that they are lower than the recent high of 2.13% set back on 11/24). 10yr yields are largely higher across the board in Italy (even Bunds where 10yr yields are up ~5.5bp).

FX – the DXY rose overnight after the Italian news but has faded from its highs and is now up ~20bp. The EUR hit ~1.05 overnight but has since bounced to ~1.06 (flat-to-down small). The JPY was flat at the time of the Japanese close but has since come for sale (it is off ~60-70bp vs. the USD). The NZD is down ~80bp after the unexpected resignation of the country’s PM.

Asia – most of the major Asian markets finished in the red: Japan (TPX -0.75%, NKY -0.82%), HK (Hang Seng -0.26%), HSCEI -0.71%), mainland China (SHCOMP -1.21%, Shenzhen -0.78%, CSI 300 -1.69%), Taiwan (TAIEX -0.31%), Korea (KOSPI -0.37%), Australia (ASX 200 -0.8%), and India (up ~0.5%). India was the only major market to see gains. If the Asian bourses could have stayed open for a few more hours they likely would have performed better but unfortunately they had to close in the hours immediately following the referendum. Asia-specific news was pretty quiet although the Trump/Taiwan/China news from the weekend did seem to weigh on sentiment a bit. The services PMIs didn’t have a huge impact on trading.

Japan – it was an extremely quiet session to start off the week with a Risk-Off mood after a “no” vote in Italy. NKY traded lower as $/¥ couldn’t reclaim its ¥114 level after the dip over the last weekend post US NFP and ahead of the referendum. The rotation into Beta has run out of steam with Banks -1.8%, Insures -0.8%, Other Financials -1.4% lagging. On the flip side, Cyclicals remained strong as all commodity-related including Shippers +0.3%, Trading cos +0.3%, Machinery +0.1% rose on the back of iron ore, crude, and coking coal. In single stocks, SUMCO +3.8% rose on news Chinese Group may acquire wafer maker Siltronics as consolidation reignited hope for wafer price hikes. CHUGAI fell 2.2% on Shire’s report of adverse events FEIBA when used with a biosimilar to ACE910 for hemophilia (Roche/Chugai). SQUARE ENIX rose +3.5% on weekend Final Fantasy 15 sales updates. FAST RETAILING fell -2.2% on WTE SSS in November showing the divergence in 1H and 2H November results in the sector. Within retails, Ryohin Keikaku -0.3%, Adasria -4.4% slumped on inline Nov. SSS while only United Arrows +0.9% bucked the weak trend.

Greg Blotnick – Metals

Hong Kong/China – HSI headed slightly lower -0.26% following a series of macro headwinds (Italy and Trump/Taiwan). SHCOMP underperformed on fear of trade/currency war with the US (Trump’s Sun night tweet didn’t help). Sector wise Rails -2.1%, Steel -1.9% and Infrastructure -1.7% plays were hit the most while Macau gaming stocks +2.1% were the clear outperformer. Macau ripped on ongoing re-rating and headed back towards 52-week highs; JPMorgan’s DS Kim raised PTs across the board to model the secular growth (Galaxy +2.5% Wynn +3.5% Sands +2.05%). For the HK insurers, Daily reported that China Unionpay card Nov overseas insurance deals plunged, AIA +0.55% reacted negatively and came off its highs. In the HK props CKP -1.26% fell hard after the announcement it will acquire aircraft leasing operations from CK Hutch -0.43%. Additionally CK Infrastructure -0.31% made a firm offer to acquire Duet Assets for A$3/ share, or a 28% premium. In the auto space, BYD -3.42% broke down on further speculation of EV subsidy cuts; Brilliance +1.31% pushed higher on growth expectations. Lonking reacted very positively to the positive profit update up 7.50% in a red tape.

US macro update – tying all the recent moving pieces back to the SPX results in a relatively unchanged outlook. Improving nominal growth (a trend underway well before the election), anticipation of the Trump/Ryan fiscal/regulatory agenda, favorable seasonality, and performance anxiety/chasing from people left behind by the post-11/8 rally are acting as tailwinds but headwinds include higher yields, a stronger USD, very elevated political expectations, and growing headline risk around trade/foreign policy. Central banks have been an afterthought lately but two important decisions will be made in the next two weeks as Draghi and the ECB (on Thurs 12/8) announce the fate of the post-Mar APP (the market is anticipating a 6 month extension at the current EU80B pace) while Yellen and the Fed (on Wed 12/14) not only hike rates (which is widely expected) but update their 2017 dot and growth forecasts to account for the myriad recent economic developments (improved nominal growth, 4.6% UR, the potential for stepped up fiscal stimulus, etc.).

December 5, 2016
2017 Outlook – The Trump Playbook

Trump On Rally
Interest rates and inflation expectations have jumped over the past five months on the back of a tight labor market and the promise of Trump’s pro-growth policies. While the market’s recent rotation might seem abrupt, the S&P 500 is up only 3% since election day, leaving it with substantial potential upside.2017 S&P 500 Price Target of 2,500
In our post-election report “A Whole New World – Biggest Paradigm Shift Since Reagan”, we wrote, “we believe that rising earnings and multiples will push equity returns into the double digits from our previous high-single-digit baseline.” Consistent with this view, we are initiating a 2017 price target of 2,500, representing 12.4% potential upside (before
dividends) from our current target of 2,225. See pages 4–5 for details.
EPS to Reaccelerate (2016: $119, 2017: $128, 2018: $140)
Following two years of near-zero growth, we expect profits to re-accelerate. A better
operating environment for Financials and Energy should contribute to faster growth in 2017 (+7.6%). 2018 EPS growth (+9.4%) assumes a 2–3% impact from Trump policies. This place holder for changes in taxes, regulation, and spending is quite modest, in our view, as an adjustment to corporate taxes alone could easily double this impact.

Upside to Multiples
Our 2017 year-end target is predicated on a 17.9x multiple on 2018E profits. 2016’s target
assumes 17.4x on 2017E EPS. We believe multiples will advance more quickly than earnings over the near term, as analysts wait for clarity on Trump policies before adjusting estimates. Markets Advance/Rotation in the Early Innings Small Caps and Financials are leading the broader market, up 10.6% and 12.3%, respectively, since the election. The market has been quick to reward low-P/E stocks and those with higher price volatility, as well as names with higher effective tax rates and more domestic business models.

10-year Treasury yields are up 53 bps since election day, 102 bps since July’s low. Bund and
JGB yields have not kept pace with Treasuries, resulting in a stronger dollar.

Cutting Top U.S. Corporate Tax Rate to 22%

Cutting corporate tax rates will boost the U.S. economy. But Trump’s 15% target is too low.

If President-elect Donald J. Trump and the new Congress are serious about firing up the U.S. economy, they will move swiftly to cut the corporate tax rate, now the highest in the world.

That one step would have far-reaching effects. It would make American businesses more competitive in the global arena. It would reduce the massive amounts of time and energy now wasted on tax-avoidance maneuvers. And it would bring home to these shores trillions of dollars of profits earned by U.S. corporations overseas and now housed in kinder tax jurisdictions.

Trump seems to appreciate all of that. On the campaign trail, he proposed slashing the rate that businesses pay on income from 35% to 15%. That might be too much—it could significantly reduce the government’s tax haul and add to the nation’s already unacceptable debt burden. Barron’s recommends a cut to 22%, which would be revenue-neutral, allowing businesses to produce just enough additional taxable income to offset the effect of the lower rate. And getting a 22% cut through Congress would be easier than 15%.

THE IDEA OF A revenue-neutral cut in the corporate income tax harks back to 1978, when economist Arthur Laffer was first cited as arguing that some tax cuts could generate enough added economic growth that the government would not lose revenue over the long term. Laffer also noted that most tax hikes generate less revenue than a conventional “static” analysis indicates, and most tax cuts lose less.

Laffer’s “dynamic” analysis covers all of the behavioral changes likely to result from a cut. To begin with, if the tax collector claims a lower share of income, there is an incentive to produce more income. Second, a lower rate means there’s less incentive to spend time and effort avoiding the tax.

That second factor—less tax avoidance—applies with special force to a rollback in the corporate income tax.

While granting tax breaks to big corporations goes against the grain of American populism, so should ceding the economic advantage of lower corporate rates to every other major industrialized country. And given the huge sums involved, it’s not hard to see why American companies operating abroad actively shop for low-tax jurisdictions.

Take corporate “inversions,” which many lawmakers deride as un-American. In an inversion, a U.S. multinational company is acquired by a company domiciled in a low-tax country, such as Ireland or Canada, where top rates are 12.5% and 26.7%, respectively. Profits earned in the U.S. continue to be taxed at the domestic rate, while those made elsewhere are subject to lower rates.

Democrats have cynically sought to outlaw inversions, rather than lower domestic tax rates, which would solve the problem by eliminating the reason companies seek out other residences. In effect, it’s a form of protectionism, and it doesn’t work.

Another tax-avoidance strategy is to locate subsidiaries in low-tax jurisdictions and to keep accumulated profits offshore; hence the roughly $2 trillion held abroad by U.S. corporations that are loath to repatriate this money because it would be subject to high U.S. taxes. Here again, a lower rate would bring revenue back to the U.S., rather than stranding it abroad.

Then there is the tricky business of transfer pricing. For example, a U.S. company purchases materials from a subsidiary in Ireland, where the tax on corporate income is much lower. Within limits, the price of the purchased materials will be exaggerated, thus reducing the profits of the U.S.-based company and boosting the earnings of that firm’s subsidiary in the low-tax jurisdiction.

THROUGH TRANSFER PRICING, then, prices on intra-corporate sales and purchases are set too high or too low, depending on the direction of the transaction. While Washington has tried to deal with cheating in this area—a wasteful exercise in itself, leading to costly litigation—it is obviously impossible to determine “correct” prices.

A tax reduction would reduce all of these incentives, generating more revenue for the U.S. Treasury. And by encouraging greater investment in the domestic economy, it would generate more revenue by resulting in more profit.

The Washington, D.C.–based Tax Foundation has argued that Trump’s tax-cut plan would result in a decline in government revenue because it “will encourage more investment and result in businesses deducting more capital investments, which would reduce corporate taxable income.” But over a 10-year time horizon—which the Tax Foundation itself studies—more capital investment will yield more profit and hence more taxable income.

And in the shorter run, there is the tax revenue generated by secondary effects. More revenue would come from shareholders, as they benefit from greater dividends and capital gains. And more would come from corporate employees, as they benefit from higher wages and salaries generated by higher spending on capital investment.

Over time, and taken all together, the revenue effects from a tax cut could even be positive. Meanwhile, the boost to economic activity would be palpable. Most of America’s trading partners have already discovered the dynamic supply-side effects of this tax cut.

Over the past 35 years, other countries have trimmed their top corporate rates by a far greater proportion than the U.S. Virtually every comparison between the burden of corporate taxes in the U.S., including state and local levies, and the rest of the world has shown that America’s burden is higher than most.

For example, as the chart shows, the top rate in the U.S., which combines the federal rate of 35% with four added percentage points for states and localities, comes to 39%. That’s higher than the combined rates for Germany (30.2%) and Japan (30%), and much higher than the United Kingdom’s (20%) and Denmark’s (22%).

Critics of corporate tax reductions point to the many loopholes that creative accounting already exploits. But according to one study, the effective corporate tax rate, which factors in these loopholes, still leaves the U.S. as No. 2 in the world in terms of its corporate tax burden, and noticeably higher than Canada and even “socialist” Sweden.

Harvard University economist Gregory Mankiw argues that corporations themselves are not the beneficiaries of tax cuts, contending that they are not really taxpayers, but rather tax collectors. It’s therefore an open question as to which of the corporate stakeholders is bearing the main burden of the tax. Many would say that it’s the company’s stockholders, with bondholders also contributing; others might say that the company’s customers pay up, as well.

Cato Institute senior fellows Chris Edwards and Daniel J. Mitchell take that idea a step further in their 2008 book, Global Tax Revolution, where they make the plausible argument that, in today’s world, the taxpayers are mainly the workers. “The burden of corporate taxes in the globalized economy,” they observe, “mainly falls on average workers in the form of lower wages. If U.S. and foreign semiconductor and pharmaceutical companies are not building factories in America because of higher taxes, it is American workers who lose.”

BUT IF YOU CAN RUN, you can’t hide. Companies have to pay taxes to some jurisdiction. If corporate rates across countries have been lowered over the years, then those who doubt the Laffer effect will expect that revenue from this tax has declined, especially given the tendency for companies to flee to lower-tax jurisdictions.

Barron’s tested this idea by updating a statistical run originated by Cato fellows Edwards and Mitchell. The results not only confirmed the Laffer effect but if anything, showed that a decline in the corporate tax rate seems to bring a rise in revenue, rather than a fall. In other words, instead of being revenue-neutral, the proposed cut might even be revenue-positive.

For 19 countries in the Organization for Economic Cooperation and Development—including the U.S., the U.K., Ireland, France, Japan, Germany, Switzerland, Denmark, Sweden, New Zealand, and Australia—Barron’s used that organization’s numbers to calculate a simple average, over time, of the top rate on corporate income, as tracked by the first line in the nearby chart.

In 1981, the earliest year for which data are available, the average top rate was 47.6%. By 2014, the most recent year for which data are available, the average had plunged to 27.4%. This decline of more than 20 percentage points came with only partial participation by the U.S., whose top rate, including state and local, fell by only 10.6 points over this period, to 39.1% in 2014 from 49.7% in 1981.

The decline in the average over each of these intervals was widespread. Fifteen out of 19 nations had lower top rates in 1995 than in 1981, and 18 of the 19 had lower top rates in 2014 than in 1995.

This collective race to the bottom conceivably could have brought a decline in revenue, but it seems to have brought just the opposite. The OECD provides figures for each country on revenue from the corporate tax, as a percentage of each country’s gross domestic product. From these figures, Barron’s calculated a simple average for the 19 countries for each snapshot year.

The figures are sensitive to the strength in the global economy; slow growth tends to lower revenue as a share of GDP, while faster growth leads to higher revenue. But the pattern is unmistakable. In 1981 and 1985, when the average tax rates were highest (47.6% and 47.8%, respectively), the tax takes as a share of GDP were at their lowest (2.1% and 2.3%). In 2000 and 2005, the tax takes were at their highest (3.5% and 3.3%, respectively), while the rates were among the lowest (35.4% and 31.1%).

Perhaps most decisively, the average tax rate in 2014 was at its lowest, at 27.4%. The tax take in 2014, at 2.7%, reflects slow growth. But in 1995, the take was at 2.5%, even though the average tax rate was more than 10 percentage points higher, at 37.5%.

“Despite complaints that corporate tax cheating is rampant and getting worse, these trends show the reverse. Tax avoidance seems to have fallen, which is one of the beneficial effects of rate cuts that all sides of this issue can support,” says Cato’s Edwards.

WHAT SORT OF REDUCTION works best? Out of concern for rising debt and deficits, and for the need for the White House and Capitol Hill to focus on the much harder task of cutting spending, Barron’s proposes a conservative approach.

In their Sept. 29 white paper, “Scoring the Trump Economic Plan,” Trump economic advisors Peter Navarro and Wilbur Ross propose reducing the top federal rate on corporate income to 15% from 35%. However, if the tax is meant to pay for itself, that 15% target may be too low.

A 2007 study by American Enterprise Institute scholars Alex Brill and Kevin Hassett (“Revenue-Maximizing Corporate Income Taxes”) found that there is indeed a Laffer effect with respect to lowering corporate income taxes. They estimated “about 26%” as the “revenue-maximizing point,” where revenue would actually run positive.

Barron’s favors this 26% target, which translates into 22% on the federal level, factoring in the extra four percentage points for corporate income taxes levied by states and localities. In order to bring the overall corporate tax rate to 26%, then, this means lowering the top federal rate to 22% from its current 35%, assuming the extra four percentage points remain unchanged.

Advisors Navarro and Ross address another issue: They propose a one-time “amnesty rate” of 10% to induce repatriation of the $2 trillion in profits that U.S. corporations are keeping offshore.

Since these companies have already paid taxes in the host countries where the money was earned, a case can be made for a zero rate. However, given concerns about possible revenue losses over the short term from a cut in the top rate, Barron’s favors the compromise of a 10% charge.

Last week, The Wall Street Journal reported that U.K. Prime Minister Theresa May endorsed a move to lower her nation’s top corporate rate from 20% to 17% by 2020. Other countries might respond with further cuts in their rates, which could give Trump support to get to 15%. Meanwhile, we favor 22%, because it encourages companies to invest more, while not reducing tax revenue.

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